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Additions
First Asset Canadian REIT ETF (TSX: RIT) – In the REIT space, this is the only actively managed ETF available. It is managed by the team of Lee Goldman and Kate MacDonald, using a bottom up, fundamental investment process that looks for growth oriented REITs with high quality assets, low payout ratios, and reasonable leverage. In addition to asset quality, the team looks for REITs or REOCs in higher growth markets that can add value through development or intensification. They like companies that are fully financed and are less dependent on the capital markets to allow them to effectively execute their strategy.
The weights of the underlying REITs are determined by the Manager based on their view of the potential risk reward tradeoff, rather than company size or equally weighted as is the case with the other REIT ETFs. I believe this allows for the potential of better risk adjusted returns over the long term from the Managers ability to actively manage the risk profile of the portfolio. That has certainly been the case, with RIT outperforming both iShares S&P/TSX Capped REIT ETF (TSX: XRE) and BMO Equal Weight REITs ETF (TSX: ZRE) in down markets.
Further, the volatility of RIT has been lower than the others while the longer-term return numbers have been stronger. For the three years ending November 30, RIT has generated an annualized return of 13.7%, more than doubling the returns of both ZRE and XRE. Shorter term however, the more passive peers have outperformed.
The portfolio of RIT is different than the peers with greater exposure to smaller cap REITs that aren’t included in the REIT index. It is also better diversified, holding nearly 60 names, rather than less than 20 for the passive strategies. This has resulted in marginally better valuation numbers and growth metrics than the peers, which allows for a higher probability of outperformance over the long term.
The biggest drawback to this ETF is the cost. It carries a management fee of 0.75%, compared to 0.55% for its passive peers. This higher cost can be a headwind, in flat or falling markets, or if the Manager cannot find attractive investment opportunities. Another potential concern is the REIT market in Canada is somewhat limited, which means that if the ETF continues to grow, it may have to look to larger REITs, and start investing in more index type names, making it look more like its passive peers. In speaking with First Asset, there remains significant runway before they believe this will become an issue.
Still, I remain very confident in the ETF and its management team. As we head into a more challenging interest rate and real estate environment, I would prefer an active manager at the helm who can navigate the portfolio to best position it for the available opportunity set, rather than a passive portfolio that simply mirrors an index.
Deletions
BMO Equal Weight REIT Index (TSX: ZRE) – I am removing ZRE from the ETF Focus List because I believe that as we head into a potentially more challenging environment, investors will be better served by an active mandate in the REIT space. ZRE provides investors with equal weight exposure to the REITs held in the S&P/TSX Capped REIT Index. I prefer it over the iShares S&P/TSX Capped REIT Index ETF (TSX: XRE) because the equal weight construction methodology can result in less concentration. For example, at the end of November, the top ten holdings of ZRE made up 56% of the portfolio compared to 83% for XRE. Further, the top name in XRE, RioCan REIT is nearly 18% of the ETF, compared with a more modest 5.5% in ZRE.
I do like this ETF for those looking for passive REIT exposure, or where costs are an issue. That said, I believe RIT will outperform on a risk adjusted basis over the long-term.
ETFs of Note
Vanguard Canadian Aggregate Bond ETF (TSX: VAB) – This has been my top pick for a core Canadian bond ETF for the past year with its rock bottom MER being a key reason for that choice. However, in the summer BlackRock, the issuer of the iShares ETFs cut the management fee on it’s core offering, iShares Core Canadian Universe Bond Index ETF (TSX: XBB) to 9 basis points. This is now lower than Vanguard’s VAB which carries a management fee of 12 basis points.
In addition to the cost structure, there are some other differences between the two ETFs. Vanguard follows the Bloomberg Barclays Global Aggregate Canadian Float Adjusted Bond Index, while XBB tracks the FTSE/TMX Canadian Universe Bond Index. Both have comparable durations of roughly 7.6 years, and yield to maturity of 2.3%. The key difference between the two is VAB has a higher exposure to government bonds, with roughly 77% in governments, compared with just over 70% for XBB.
Over the longer term, VAB has modestly outperformed XBB on both an absolute and risk adjusted basis. Over the past year however, with increasing pressure on yields, it has begun to trail because of the higher government exposure. However, when things get rocky in the equity markets, I would expect VAB to outperform slightly on the flight to safety trade as investors prefer the government bond exposure.
Over the next quarter or two, I will continue to monitor both ETFs, and will evaluate the potential impact of the lower cost of XBB on its future expected return stream.
First Asset Morningstar Canadian Momentum ETF (TSX: WXM) – This momentum focused ETF had a bit of a rough go in 2015 and 2016 when it trailed the broader Canadian market after handily outperforming in 2013 and 2014.
This, and other momentum strategies are based on the premise that outperforming stocks tend to perform into the future. First Asset uses Morningstar’s proprietary CPMS program to score Canadian companies on six factors; trailing return on equity, 3-month EPS estimate revisions, latest quarterly earnings surprises, as well as three and nine-month prices change, and change in price from its 12-month high. The score for each stock is determined and the top 30 names make up the portfolio. These screens are run quarterly.
The portfolio will often look much different than the broader index. One key difference is the market cap tends to skew much lower than the index, and at the end of November was $6.3 billion, roughly a third of the broader market. From a sector perspective, it is also different with significant underweight positions in energy and financials, while holding overweight exposure to technology, communications, and consumer names. Over the past three months, the ETF has experience strong gains from Parex Resources, West Fraser Timber, and Labrador Iron Ore Royalty Corp.
The cost is higher than with more passive indices with an MER of 0.68%, which is well above the 0.06% MER of the iShares S&P/TSX Capped Composite Index ETF (TSX: XIC). The higher the fee hurdle, the greater the potential headwind.
Looking ahead, I expect this ETF to be able to deliver above average returns over the long-term. However, because it is style specific, it is very likely there will be shorter periods of time where its performance is dramatically different than the broader market. Further, given the more mid-cap exposure, it is possible there may be periods of above average volatility. It is for these reasons I would be reluctant to use this as a core holding. Instead, I see it as a potential diversifier; adding potential return while helping to mitigate overall portfolio volatility when used as a piece of a well-diversified portfolio.
Vanguard U.S. Total Market ETF (Canadian dollar hedged) (TSX: VUS) – The objective of this ETF is to replicate the performance, net of fees, of the entire investible U.S. equity market. Indirectly, it holds 3600 securities, compared with the iShares Core S&P 500 (CAD-Hedged) ETF (TSX: XSP) which has exposure to 500. As a result, it has more small and mid-cap names than XSP. At the end of November, approximately 18% was invested in mid-caps and 9% in small caps. In XSP, 13% was invested in mid-caps and no small caps. It carries an average market capitalization that is a little more than half XSP. It is this broader market exposure that sees VUS with a slightly more attractive valuation profile over XSP. This more favourable valuation is expected to be a positive over the long-term.
Turning to the sector mix, it tracks XSP closely, with a couple exceptions. VUS is underweight technology, financials, and consumer defensives, while it is overweight real estate, industrials, and materials.
In practice, both XSP and VUS are a great way to access the U.S. equity market. Performance of the two have been similar with XSP slightly outperforming. XSP has been a touch less volatile largely because of the lower weight to small and mid-cap holdings. Further, the higher weight in technology and financials has also helped XSP earn its modest outperformance in recent quarters. Looking ahead, I would give a very slight edge to VUS for two reasons – its more attractive valuation profile, and higher weight in small and mid-caps, which can offer a stronger growth profile over the long-term.
iShares International Fundamental Index ETF (TSX: CIE) – Over the past quarter or two it appears the market is once again paying attention to quality and valuation, with this fundamentally constructed ETF gaining 8.2%, handily outpacing the other foreign ETFs on the Focus List.
CIE selects companies based on fundamental factors including dividends, free cash flow, sales, and book value. Each year, the companies that are in the FTSE Developed All Cap ex-U.S. Index are scored and ranked on the fundamental factors. The index is rebalanced quarterly.
One of the flaws of the traditional market cap weighting methodology is the potential for there to be overweight exposure to the most overvalued names. Using a fundamental approach is designed to reduce this potential by having those companies with the more attractive fundamentals make up a larger part of the portfolio.
Looking at the portfolio, this is indeed the case with valuation metrics that are considerably more attractive than the benchmark. At the end of November, CIE trades at a P/E ratio that is 15% lower than the broader market and a dividend yield nearly 10% higher. This certainly looks compelling from a long-term outlook perspective.
The biggest drawback to this and other “smart beta” ETFs is cost, with an MER of 0.72%, well above its passive peers.